If done properly, individuals should never pay income taxes on the sale of a property if they intend to reinvest the proceeds of a sale of property in a similar or like-kind property.
The advantage of a like-kind or Section 1031 Exchange is the ability of a taxpayer to sell investment or business property and replace with like-kind replacement property without having to pay federal income taxes on the gains of the transaction. Unfortunately, a simple sale of property and subsequent purchase of a replacement property will not qualify for a tax-free exchange. Instead, there must be an exchange that satisfies the stringed rules of Section 1031 of the Internal Revenue Code.
Typically, a taxpayer will benefit from the use of a Section 1031 exchange. However, there could be disadvantages to using a Section 1031 exchange. A potential disadvantage is a reduced basis for depreciation in the replacement property.
There are several ways to structure an exchange. The most common way to structure such an exchange is to use an intermediary, direct deeding, and an escrow account for the temporary holding of exchange funds. Exchanges can also occur without the services of an intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other.
BASIC RULES OF TAX DEFERRED EXCHANGES
Qualifying property is property (or equipment) held for investment purposes or used in a taxpayer’s trade or business. Investment property includes real estate, improved or unimproved, held for investment or income-producing purposes. Property used in a taxpayer’s trade or business includes his office facilities or place of doing business, as well as equipment used in his trade or business. Real estate must be replaced with a like-kind real estate. Equipment must be replaced with like-kind equipment.Property Which Does Not Qualify For A 1031 Exchange includes –
The replacement property title must be taken in the same names as the relinquished property was titled. If a husband and wife own property in joint tenancy or as tenants in common, the replacement property must be deeded to both spouses, either as joint tenants or as tenants in common.
For real estate exchanges, like-kind replacement property means any improved or unimproved real estate held for income, investment or business use. The improved real estate can be replaced with the unimproved real estate. The unimproved real estate can be replaced with the improved real estate. A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice-versa. One property can be exchanged for two or more properties. Two or more properties can be exchanged for one replacement property. Investment property can be exchanged for business property and vice versa. However, as referenced above, a taxpayer’s personal residence cannot be exchanged for income property, and income or investment property cannot be exchanged for a personal residence, which the taxpayer will reside in.
The term “boot” is not used in the Internal Revenue Code or the Regulations. It is also commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject. “Other property” is a property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes promissory note received from a buyer.
TYPES OF EXCHANGES
A Simultaneous Exchange is an exchange in which the closing of the relinquished property and the replacement property occur on the same day, usually back-to-back. There is no interval of time between the two closings. This type of exchange is covered by the Safe Harbor Regulations.
A Delayed Exchange is an exchange where the replacement property is closed on at a later date than the closing of the relinquished property. There are strict time frames established by the Tax Code and Income Tax Regulations for these types of exchanges.
A Reverse Exchange is an exchange in which the replacement property is purchased and closed on before the relinquished property is sold. Usually, the intermediary takes title to the replacement property and holds the title until the taxpayer can find a buyer for his relinquished property and close on the sale under an exchange agreement with the intermediary. Subsequent to the closing of the relinquished property or simultaneous with this closing, the intermediary conveys title to the replacement property to the taxpayer.
An Improvement Exchange is an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. The improvements are usually a building on an unimproved lot, but also include enhancements made to an already improved property in order to create adequate value to close on the exchange with no boot occurring. The Tax Code and Income Tax Regulations do not permit a taxpayer to construct improvements on a property as part of a 1031 Exchange after he has taken title to the property as replacement property in an exchange. Therefore, it is necessary for an intermediary to close on, take a title and hold title to the property until the improvements are constructed and then convey title to the improved property to the taxpayer as replacement property. Improvement Exchanges are done in the context of both Delayed Exchanges and Reverse Exchanges, depending on the circumstances.
Taxpayers entering into 1031 Exchange markets his or her property for sale in the normal manner without regard to the contemplated 1031 Exchange. However, special language is usually placed in the contract securing the cooperation of the buyer to the seller’s intended 1031 Exchange.
When contingencies are satisfied and the contract is scheduled for a closing, the services of an intermediary are arranged for. The taxpayer enters into an exchange agreement with an intermediary. The intermediary then becomes the seller of the property.
The Exchange Agreement usually provides for:
- An assignment of the seller’s contract to buy and sell real estate to the Intermediary.
- A closing where the intermediary receives the proceeds due the seller at closing.
- The exchange agreement must provide that the taxpayer can has no rights to the funds being held by the intermediary until the exchange is completed.
- The seller must locate replacement property or properties and enter into a contract to purchase the property or properties within a strict time frame.
- At closing the intermediary uses the exchange funds in his or her possession to acquire the replacement property for the seller.
The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on replacement property or to identify the potential replacement property within 45 days from the date of transfer of the exchanged property. The 45-Day Rule is satisfied if replacement property is received before 45 days has expired. The identification must be by written document signed by the taxpayer. The identification must either be hand-delivered, mailed, faxed, or otherwise sent to the intermediary. The identification notice must contain an unambiguous description of the replacement property. This includes, in the case of real property, the legal description, street address or a distinguishable name.
After 45 days, limitations are imposed on the number of potential replacement properties which can be received as Replacement Properties. More than one potential replacement property can be identified under one of the following three conditions:
The Three-Property Rule – Any three properties regardless of their market values.
The 200% Rule – Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
The 95% Rule – Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.
The replacement property must be received and exchange completed no later than the earlier of 180 days after the transfer of the exchanged property or the due date with extensions of the income tax return for the tax year in which the exchanged property was transferred.
As stated above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the exchange is not complete by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the unwary.
Reverse Exchanges occur when a taxpayer arranges for an Exchange Accommodation Titleholder (EAT) (usually the Intermediary) to take and hold title to replacement property before a taxpayer finds a buyer for his relinquished property. Sometimes the exchange accommodation titleholder will take and hold title to the relinquished property until a buyer can be found for it. Reverse Exchanges have been common and have been preferred in circumstances where a taxpayer has been compelled to close on replacement property before a relinquished property could be sold and closed or where the taxpayer desired ample time to search for suitable replacement property before selling a relinquished property which started the well-known 45 and 180-day clocks for Delayed Exchanges.
Reverse Exchanges have also been common where a taxpayer wants to acquire a property and construct improvements on it before taking title to the property as replacement property for an exchange. The Reverse Exchange gave the taxpayer extra time to get the improvements constructed in addition to the 180-day clock referred to above.
Procedures of a Reverse Exchange impose the following requirements:
- The 5-Day Rule. A “Qualified Exchange Accommodation Agreement” must be entered into between the taxpayer and the exchange accommodation titleholder (qualified intermediary in most cases) within five business days after title to property is taken by the exchange accommodation titleholder in anticipation of a Reverse Exchange.
- The 45-Day Rule. The property to be “relinquished” (the relinquished property) must be identified within 45-days. More than one potential property to be sold can be identified in a manner similar to the rules of delayed exchanges (i.e., the three-property rule, the 200% rule, etc.)
- The 180-Day Rule. The Reverse Exchange should be completed within 180-days of taking title by the exchange accommodation titleholder.
As stated above, Reverse Exchanges should be completed within 180-days. However, there is some legal authority which indicates that a Reverse Exchange replacement property may be named outside the 180-day window.
The role of the qualified intermediary is essential to completing a successful and valid delayed exchange. The intermediary is not considered the agent of the taxpayer. A written agreement between the taxpayer and intermediary limiting the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.
An intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into an agreement for the transfer of the relinquished property and thereafter to assign his rights in that agreement to the intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as having entered into the agreement and, upon completion of the transfer, as having acquired and transferred the relinquished property.
The Tax Code prohibits certain “agents” of the taxpayer from being an intermediary. These agents include accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years.
POTENTIAL TAX LIABILITY ASSOCIATED WITH 1031 EXCHANGES
In order for an exchange to be completely tax-free, there must be no taxable gain or boot received by the taxpayer. The term “boot” is not used in the Tax Code or the Income Tax Regulations. However, this term is commonly used in discussing the tax consequences of a Section 1031 exchange. Boot received is the money or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject to. “Other property” is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes such things as a promissory note received from a buyer.
The most common exam of boot is cash received when a taxpayer acquires property that does not cost as much as the relinquished property sold for.
Boot may also occur when a taxpayer’s debt on replacement property is less than the debt which was on the relinquished property.
In addition, a taxpayer may also recognize boot through excess borrowing to acquire the replacement property. Borrowing more money than is necessary to close on replacement property will cause cash being held by an intermediary to be excessive for the closing. Excess cash held by an intermediary is distributed to the taxpayer, may result in cash boot to the taxpayer.
RELATED PARTY EXCHANGES
There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years after the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two-year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs.
Related parties under the rules are the following
- Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);
- An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
- Two corporations that are members of the same controlled group;
- A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
- A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;
- Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;
- A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person’s family;
- A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;
- Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
- Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or
- An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
- Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or
- A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.
Investment real estate is commonly owned by co-owners in a partnership containing two or more partners, or by co-owners as tenants in common. An exchange of a tenant in common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations.
If a partnership owns property and desires to sale/exchange the property, then the partnership is the entity that is the Exchanger and party to the Exchange Agreement. The partnership will take title to the replacement property.
Frequently, individual partners in a partnership desire to take their share of the proceeds of sale of the partnership property, replace with qualifying 1031 replacement property in their own names and end their relationship with the partnership. This presents problems that require careful planning and is not without tax risk.
If a two-partner partnership wishes to discontinue the partnership, sell the property and go their separate ways with either the cash or a 1031 Exchange, it is necessary for the individual partners to receive a deed to the property from the partnership in advance of the sale of the property. This is done in the context of a distribution of property from the partnership to its partners. The individual partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the “held-for” requirement of 1031 Exchanges that requires a taxpayer to have “held” qualifying property for business or investment purposes prior to the exchange.
If a partnership with multiple partners wishes to exchange property but some of the partners want to “cash-out” or go separate ways, it is common for the partnership to do a “split-off.” The partnership distributes tenancy in common title to a portion of the partnership property to those individual partners who wish to proceed in separate directions, and the partnership (and its remaining partners) proceed with an exchange in the name of the partnership.